TCF summary

Week 1

Additivity: the value of a firm is the sum of the values of different projects, divisions or other
entities. So, the contribution of a project toa firm’s value is simply the NPV of the project.

Discount rate: opportunity rate. Return that one can expect to earn on a financial asset of
comparable risk.

Perpetuity: stream of cash flows forever. PV = C/ r

Annuity: stream of cash flows for fixed period of time.

NPV:

NPV = -30.000 + 6000 * annuity factor + 2000 / 1.15^8

Payback rule:
Payback period: time taken for initial investment to be repaid out of project net cash inflows.
Cumulative cash till it is equal to zero, till that period is payback period.

Discounted payback:
Discount cash flows. As long as cash flows and discount rates are positive, discounted
payback period will never be smaller than payback period because discounting reduces value
of cash flows.

ARR:
Average accounting return. Average net income / average investment.

IRR:
Discount rate which produces zero NPV.
- Accept project if IRR is greater than NPV (NPV will be positive)
- Reject project if IRR is less than NPV (NPV will be negative)
Intuition: higher IRR better investment. But this is not always true. For lower discount rates,
lower IRR can be better.

Profitability index
PV of future cash flow divided by initial costs.
Accept if PI is bigger than 1, reject if PI is smaller than 1.

MIRR
Modified internal rate of return. If cash flows are reinvested elsewhere.

-1

Margin of safety
1 – initial investment / PV of future cash flows. Lower than safety margin, reject.

Capital investment decisions

- CF at the beginning of the project.
- CF during project

Depreciation is non-cash cost, but tax deductible expense. So added later on.
NWC = short term asset – short term liabilities

Relevant cash flow?

- Opportunity cost
- No sunk costs
- Include all side effect
Erosion: reduces the cash flows of existing products
Synergy: increases the cash flows from existing products.
- CF at the end of the project
Replacement projects:

Inflation
Nominal cash flows must be discounted at a nominal rate, real cash flows must be
discounted at a real rate.
h is inflation percentage
- Nominal cash flow and NWC is actual money in cash to be received.
- Real cash flow is purchasing power.
- Depreciation is a nominal quantity. Does not change for inflation.
Real interest rate: (nominal discount rate / inflation rate) – 1

- Knom and OCFreal – inflate OCFreal and convert into OCFnom.

= OCFnom = OCFreal * (1+h)
- Kreal and OCFnom – deflate OCFnom and convert into OCFreal
= OCFreal = OCFnom / (1+h)

With taxes
Unequal project lives

Calculate equivalent annual cost of each machine.

PV = PV per year * Annuity factor

Now you can compare equivalent annual costs of machine A to B. Choose B because costs
are lower.

If the salvage value is less than the book value, the selling of the asset will not be taxed. If
there are other taxable profits, it will receive a tax gain on the loss.

Opportunity cost: keep machine that could be sold: Save taxes which will be deducted from
the costs.

Week 2
Expected return: cost of equity capital

Rm is market, Ri is firm. (Or SD firm + Correlation / SD

market)
Intercept of the beta line is alpha. Slope of the line is beta.
Lower beta means relatively lower risk.

Share price

For preference shares: P0 = DIV/Rp (perpetuity because of fixed dividends)

Unlisted firm:

With Bdebt = 0

If a project’s beta differs from that of the firm, the project should be discounted at the rate
that reflects project risk rather than firm risk. If not, bias would result: accept too many high-
risk projects and reject too many low-risk projects.
So use industry beta. But beta of a new project may be higher than existing beta: due to the
newness of the project it is likely to increase responsiveness to economy-wide movements.
(Fail in recession, or grow even harder in expansion) – So adjustment needed: higher beta.

Firm with debt

Interest is tax deductible, so cost of debt:

Or interest expense / total borrowings.

And therefore for levered firm:

(wacc)

- Market value weights are more appropriate than book value weights: market values
are closer to actual money that would be received from the sale.
- Debt equity ratio: transfer to debt-value ratio: E/D+E instead of E/D
- Rwacc van be used for NPV. If NPV is negative, financial markets offer superior
projects in the same risk class.

Bid-ask spread: broker provides a quote of 100.00 – 100.07: Buy at 100.07 per share and sell
at 100.00 per share. 0.07 spread is the cost to you because you are losing 0.07 per share
over a round-trip transaction. Therefore, low liquidity/high trading costs: high expected
return, high cost of capital.

ROA = earnings after tax / assets

EVA = (ROA-Wacc) * total capital or EBIT – WACC * total capital (economic value added)

Beta and leverage for leveraged firm

Unlevered is all-equity financed.
 Use this formula twice. First to find Bu (with other
firms values) and then to find Be again (with own firm values). (Unlever and then relever)

B unlevered can be calculated and used to calculate Bequity of leveraged firm. (Same
business risk but differ in financial risk)
Beta of levered equity must be greater than the beta of the unlevered firm, because
leverage increases the risk of equity. But less rapidly under taxes: creates a riskless tax
shield.

Selfstudy questions.
Knowledge check: interpolation question 7.

Week 3

Adjusted present value approach (APV)

Seperates project cash flows form financing cash flows and values these separately. If
positive, take project.

APV = NPV + NPVF: the value of a project to a levered firm (APV) is equal to the value of the
project of an unlevered firm (NPV) + the net presenet value of the financing side effects
(NPVF).

OCF does not include interest payments. Is included in the discount factor.

Four side effects:

- Tax subsidity to debt: Tc * D

- Cost of issuing new securities: compensation of bankers for time and effort. Lowers the
value

- Cost of financial distress: possibility of financial distress arises with debt financing. Lowers
the value

- Subisidies to debt financing: interest on debt not taxable. Adds value

Example in notebook

Flow to equity approach (FTE)

Discounting the cash flow from the project to the shareholders of the levered firm at the cost
of equity capital.

Put yourself at the position of an equity holder. (Cash flow after paying debt).
1) Calculate the levered cash flow: cash inflow - cash cost - interest = income after interest -
Tax = levered cash flow.

(Or UCF - LCF = (1-Tc)*Rd*D

2) Calculation of RE

3) Valuation/PV. Levered cash flow / RE

4) NPV: difference between PV and the investment not borrowed.

For a firm with leverage: RE must be higher than RA.

RCF = Operating profit before taxes - interest = income before taxes - taxes = income after
taxes + depreciation - increase NWC - necessary capital expenditures - repayment loan =
residual cash flows from project to equity holders.

Weighted average cost of capital method

Debt financing provides a tax subsidy that lowers the average cost of capital.

Use NPV or FtE unless:

- Valuation of leveraged buyout

- Situations with below-market interest rates, subsidies and significant flotation costs

- Lease versus buy-decisions

APV can be used in these circumstances.

Week 4

Call option: value increases 1 dollar for every 1 dollar rise in share price.
Put option: value increases 1 dollar for every 1 dollar decrease in share price.

2 factors that determine call value:

- Features of the option contract: exercise price and expiration date
- Characteristics of the equity and the market

Excersice price: increase reduces the value of the call (for put opposite)
Expiration date: value of a call with a longer time to expiration must be at least as much as a call with
a shorter time to expiration (for put as well)
Share price: the higher the share price, the more valuable the call option will be (for put opposite)
Variability: the greater the more valuable a call option (for put as well)
Interest rate: ability to delay payment is more valuable when interest rates are high. (for put
opposite)

Black Scholes model

This formula assumes there is no dividend. Dividends cause share prices to fall by the same amount
as the dividend to reflect cash leaving the company.

Week 5
Share options for managers:
- Align interest to shareholders. More likely to make decisions in benefit of shareholder
- Lower base pay of manager. Removes pressure on morale caused by disparities between employees
and managers
- Options put an managers pay at risk, rather than guaranteeing it regardless of performance.

Disadvantage: encourage manager to take on more risky projects.

Dividend payout: call worth less than without dividend: all other things being equal, dividend lowers
the share price.

Value-to-cost metric
NPVq = Present value of expected cash flow / Present value investment costs
- Smaller than 1: project is worth less than its cost
- Bigger than 1: project is worth more than its cost
NPVq goes up if V increases, I decreases, Rf increases (therefore PV(I) decreases), T-t increases
(Therefore PV(I) decreases)

Volatility metric

Volatility increases if there is more uncertainty or T-t is longer.

1: Operation at expiration, no delay possible. Execute.

6. Invest never.
2 and 3: NPVq>1. PV of FOCF is worth more than investment.  Area 2 NPV>0 and Area 3 NPV<0.
4 and 5: NPVq<1. Area 4: currently loss-making but high volatility. Area 5: very small posibility of
becoming profitable.
NPV = V-I
 
Natural movement over time:
- Upwards because volatility metric will decrease over time
- To the left because PV will decrease, therefore NPVq declines.
Want to move to the right: luck and active management.
 
When equity has delta < 1, value created will go partially to bondholders. Lower delta is more money
to bondholders.
Shareholders have strong incentive to increase the variance of return on the firm's assets.
 
Week 6
Value of cash flows determines the firm value. Changes in capital structure do not change the value.
Managers can not increase value by changing the financial sources.
MM proposition 1: no capital structure is any better or worse than any other capital structure for the
firm's shareholders. The value of the firm is always the same under different capital structures. Wacc
is constant. VL = VU.

MM proposition 2: expected return on equity is positively related to leverage because the risk to
equity holders increase with leverage.

Cost of capital can not be reduced as debt is subsituted for equity (debt is cheaper) because adding
debt makes the remaining equity more risky. As the risk increases, the cost of equity capital rises.

Rf = Ra + D/E (Ra-Rd)

MM with taxes: Wacc wil go down if more debt is added. Re will increase if more debt is added.
Value will increase if more debt is added.
Why does the firm not borrow at the maximum?
- Financial distress posibility
- Investors factor the potential future distress and bankruptcy into their assessment in their current
value.

More debt increases firm value, but cost of financial distress will lower the firm vale.
- Trade-off theory: capital structure based on trade-off between tax savings and distress cost of debt
- Pecking order theory: firms prefer to issue debt rather than equity if internal finance is insufficient.
 
Warrants
Security that gives the holder the right, but not the obligation, to buy shares directly from the
company at a fixed price for a given period of time.